Teach Your Children Well [I]
It may be the dream of every parent who owns a closely held business that one or more of their children will follow in their footsteps. They envision a time when a child will enter the business as an employee, learn the “ins and outs” of the business, pay their dues,[ii] move up the ranks and, one day, assume the mantle of leadership as the parent heads off to their new pastime,[iii] secure in the knowledge that they have left their child with a good business, and equally secure in the knowledge that the business they have built is in good hands. If all goes to plan, the parent will make a gift of equity in the business to the child, or they will bequeath the business to the child.[iv]
Unfortunately, things don’t always turn out as we hoped they would. Remember Don Corleone in the garden, after his youngest son, Michael, has told him that he has assumed control of the family business? “I never wanted this for you.”[v]
The Don foresaw the troubled life that Michael had chosen. Unfortunately, it seems that some parents would knowingly put their children in harm’s way – indeed, even throw them under the proverbial bus[vi] – and there are those children who learn all the wrong things from their parents. Both of these situations are found in the case described below.[vii]
Parents had long been engaged in the staffing business[viii] (the “Business”). After Child completed college, Parents invited Child to work in the Business. They organized a new corporation (“Corp”), of which Child was named the sole director and president, positions that Child would hold for the next twelve years.[ix]
Client businesses for which Corp provided staffing would pay Corp directly for its services. The people who were staffed at the client businesses were classified as Corp’s employees, and Corp was responsible for paying their wages and for withholding taxes from those wages.
Despite being established as the sole director and president of Corp – at least on paper – Child initially worked at locations offsite from the corporate office, under the control and direction of Parents, who in fact actively managed Corp.
After an approximately five-year period of employment with Corp (the “Earlier Period”), Child continued to work primarily offsite, though they were given additional responsibilities, some of which required Child to return to the corporate office periodically to execute a number of documents (as directed by Parents), which Child would do without reviewing.[x] Occasionally, Child would also check the corporate mail and make bank deposits, though these tasks were primarily the responsibility of Parents.
Through the Earlier Period, and just beyond, Child did not exercise any hiring or firing authority over employees, though Child would occasionally make personnel recommendations to Parents. Child had access to Corp’s checking accounts, but was not responsible for them. Most checks were signed by Parents, though Parents would occasionally ask Child to sign completed employment tax returns[xi] on behalf of Corp, which Child would do without reviewing.
Trust Fund Taxes
Corp did not pay in full its federal employment taxes for certain quarters during the Earlier Period. Parents prepared a “Report of Interview with Individual Relative to Trust Fund Recovery Penalty”[xii] on which Child was identified as the person “interviewed” – Child executed the completed form at the request of Parents.
At some point, an IRS Revenue Officer appeared at Corp’s office unannounced, and explained to Child that Corp had a “tax issue” and owed taxes. After the meeting, Child contacted Parents, and was told that they and the corporation’s attorneys would handle the tax issues.
Shortly thereafter, the IRS sent a Trust Fund Recovery Penalty (“TFRP”) Letter,[xiii] and a Proposed Assessment of Trust Fund Recovery Penalty,[xiv] with respect to Corp’s unpaid employment taxes for above-referenced quarters. The certified mail was returned to the IRS, unclaimed.[xv] The IRS assessed TFRPs against Child.
Transition in Management
During the years following the Earlier Period (the “Later Period”), new bank accounts were opened for Corp, with Child having signatory authority over a business checking general fund account, and a business checking labor payroll account. In addition, a business checking “Special Trust Fund Account” was opened to help ensure that Corp paid its tax liabilities. Child was named trustee of, and had sole signatory authority over, the Trust Fund Account.
Also during the Later Period, Child began taking over the Business in preparation for Parents’ retirement. Thus, Child assumed many of Corp’s internal operations. Child had the authority to hire and fire employees, to sign leases on behalf of the corporation, and to transfer funds from Corp’s general fund to its labor payroll account. Child had a corporate credit card and used it to make purchases. However, Child also continued to sign any documents as directed by Parents, including Corp’s tax returns.[xvi]
Transition in Delinquency
During the Later Period, Corp began to underpay its tax deposits, and its employment tax returns consistently reflected balances due. At some point, Corp’s deposits were far less than the balance due, and it oftentimes owed several hundred thousand dollars of unpaid tax on each return. Corp filed its returns and paid deposits each quarter, but the large delinquencies continued to accrue.
Inexplicably, Corp’s general fund account held funds sufficient to pay the corporation’s delinquent employment taxes, yet Child instead wrote checks out of the general fund for payments to a professional sports team and a country club, as well as other personal items.
What’s more, the funds in Corp’s labor payroll account were sufficient to have fully paid the balances reflected on the employment tax returns for several of the delinquent quarters.
Over the course of the Later Period, significant amounts were withdrawn from the Trust Fund Account that were not used to pay Corp’s employment tax liabilities.
Toward the end of the Later Period, Parents pleaded guilty to tax evasion.[xvii]
By that time, Child had fully taken over management of the day-to-day operation of Corp. Shortly thereafter, Child closed the Business.
You’re On Your Own, Kid
Child was interviewed by an IRS Revenue Officer. This was followed by a letter from the IRS indicating that Child might have some responsibility regarding Corp’s unpaid employment taxes for the Later Period.
The IRS then assessed TFRPs against Child for both the Earlier and Later Periods, aggregating approximately $2.3 million.
This was followed by a Notice of Federal Tax Lien Filing for the TFRPs with respect to the Earlier Period, and by another Notice with respect to the Later Period.
Finally, the IRS issued Child a Final Notice, Notice of Intent to Levy, and Notice of Your Right to a Hearing for TFRPs for the Later Period.
Child timely filed Requests for a Collection Due Process or Equivalent Hearing (CDP hearing requests),[xviii] in response to the two NFTL filings and the levy notice. The CDP hearing requests sought relief from the liens and proposed levy and acceptance of an offer-in-compromise or an installment agreement. Child also argued they were not a responsible person and never had the actual authority or ability to pay the taxes because Corp and its taxes were controlled by Parents.
The CDP hearing requests were assigned to a Settlement Officer (“SO”), who did not consider the substantive basis for the underlying liabilities for any of the periods in issue. Instead, the SO focused on Child’s request for an offer-in-compromise or an installment agreement. When the SO proposed a payment plan, Child’s attorney informed the SO that Child intended to close the Business and would be unable to make any proposed payments.
The IRS Office of Appeals issued Child a notice of determination sustaining the NFTLs and the proposed levy.
In response to the notice of determination, Child timely petitioned the U.S. Tax Court.[xix] Among other things, Child asserted that (1) they were not a person responsible for paying over, and they did not willfully fail to pay over, Corp’s employment taxes, and (2) Parents controlled the Business and the employment taxes.
The Court explained that an employer is required to withhold or collect from an employee’s wages the employee’s share of federal taxes,[xx] and then must pay over the withheld amounts to the IRS. Such withheld amounts are known as “trust fund taxes,” because they are “held to be a special fund in trust for the United States.”[xxi]
The Code imposes the TFRP on “[a]ny person required to collect, truthfully account for, and pay over any tax . . . who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof.”[xxii]
The term “person” includes an officer or employee of a corporation who is under a duty to collect, account for, and pay over the tax.[xxiii] Such persons are referred to as “responsible persons.”[xxiv] The TFRP shall be paid upon notice and demand by the IRS and shall be assessed and collected in the same manner as taxes.[xxv]
Child contended that they were not liable for TFRPs because they were not a responsible person who willfully failed to pay over the withheld taxes for any of the periods in issue.
The Court’s Analysis
The Court agreed that Child’s liability for the TFRPs rested on their being a responsible person with respect to the periods in issue.
Responsibility, the Court stated, was based on an individual’s “duty and authority to withhold and pay taxes.” It “does not require actual knowledge that one has that duty and authority.”
The Court explained that, among the factors indicative of such authority were whether the individual: “(i) is an officer or member of the board of directors; (ii) owns a substantial amount of stock in the company; (iii) manages the day-to-day operations of the business; (iv) has the authority to hire or fire employees; (v) makes decisions as to the disbursements of funds and payment of creditors; and (vi) possesses the authority to sign company checks.”
During the Earlier Period, Child was unaware that Corp had failed to pay its employment taxes. Indeed, Child worked under the control and direction of their parents. Child was not involved in the day-to-day management of the company, worked primarily offsite, and signed papers when asked to do so. Child did not exercise any hiring or firing authority over employees and, instead, left personnel decisions to the Parents.
Child became aware of the corporation’s failure to pay its employment taxes in full only after being informed of such by the Revenue Officer who visited the corporation’s office. Even then, Child contacted Parents for guidance and was told that they and the corporation’s attorneys would handle any tax matters.
However, Child did take a more active role in the corporation during the Later Period. Child acted upon their authority as the president and sole director of the corporation. Child was being groomed to take over the Business, and participated more actively in the management of the corporation. Child had signatory authority over the corporation’s bank accounts; in particular, Child had sole signatory authority over Corp’s Trust Fund Account, which was opened to ensure the corporation paid its tax liabilities. Child was more involved in the day-to-day operations of the corporation during this period, wrote checks from the corporate accounts, and chose to make payments for personal expenses instead of taxes.
The Court pointed out that the stark contrast between Child’s nominal duties during the Earlier Period and Child’s role during the Later Period demonstrated that Child was not a responsible person for the Earlier Period.
The Later Period presented a different story. At this point, Child was aware of Corp’s delinquent tax liabilities, and had been interviewed by a Revenue Officer about the outstanding tax liabilities. Moreover, Child could not have reasonably expected that Parents would resolve the corporation’s tax issues because they were about to be incarcerated.
Accordingly, the Court did not sustain the IRS’s determination for the TFRPs relating to the corporation’s employment taxes owed for the Earlier Period, but it did sustain the IRS’s determination for the Later Period.
What’s The Point?
Two points, I guess.
I don’t know about you, but there appear to be a lot of trust fund matters out there. Unpaid employment taxes continue to be a substantial problem. Amounts withheld from employee wages represent almost 70-percent of all revenue collected by the IRS, yet billions of dollars of tax reported on Employer’s Quarterly Federal Tax Returns (Forms 941) remain unpaid.[xxvi] The cause, in many cases, is a failing business – the latter will often divert the tax monies collected toward the satisfaction of business expenses in the hope of turning the corner; they usually don’t. The IRS’s position is that such businesses should be allowed to fail rather than taxes go unpaid.
Which brings us to the second point. We know that, in transactions between unrelated persons, before a prospective acquirer actually purchases a business from the current owner of the business, they will do a fair amount of due diligence, and they ask the current owners to make specific representations as to the “well-being” of the business and as to its compliance with applicable laws.[xxvii]
What does the beneficiary of a gift or bequest do before accepting the transfer of an interest in a donor’s or decedent’s business?
In the vast majority of cases, nothing – except, perhaps, say “thank you.” Remember the old saying, “Don’t look a gift horse in the mouth”?[xxviii]
In any case, what parent would transfer to their child an interest in a business with a closet full of skeletons? Unwittingly, perhaps; but not knowingly, except in rare circumstances, as we saw in the discussion of the Earlier Period, above.
It is important to note that the intended beneficiary of a gratuitous transfer is not required to accept such a transfer; indeed, state property law and federal tax law both provide for the beneficiary’s disclaimer or renunciation of a gift or bequest.[xxix]
In order to decide whether to accept a gift, I say, of course the intended beneficiary should count the horse’s teeth; they should ask the owner about its history and temperament; they may even want to ask a vet to check the horse.
Have you ever encountered a gift of an interest in real property that turned out to be environmentally challenged and very expensive to remediate? How about a gift of several properties that were not only expensive to maintain but also vacant, thereby requiring the beneficiary to dip into their savings in order to keep the property?
Can you say “thanks, but no thanks?” What about “fire sale?”
Of course, the timing and circumstances of the transfer may greatly impact the beneficiary’s ability to “negotiate” their receipt of the property; for instance, we never know when Thanatos[xxx] will come for us. That being said, it’s good to plan ahead.
In the case of a gift of an equity interest in a business,[xxxi] the management of which will pass to the beneficiary, it may behoove both “parties” to the transfer to identify any issues and to plan accordingly. Perhaps the donor-parent can remedy the problem in conjunction with making the transfer, rather than leave it for their child to confront. Alternatively, the parent may transfer other assets to the beneficiary, to provide a source of funds for use in tackling the problem, or as “compensation” for the reduced value resulting from the problem. If it is determined that the problem cannot be resolved, it may be advisable for the parent to sell the business before they retire, so as to maximize the net proceeds for the beneficiary child who may then have to seek employment elsewhere.
As always, it makes sense for the parties to openly and thoughtfully discuss these matters well in advance of the transfer.
[i] Apologies to CSNY.
[ii] The idioms are flowing freely today. Reader beware.
[iii] I pray it is anything but golf.
[iv] Beware, and do not forget, the children who are not in the business.
Query what the exemption amount will be when this transfer occurs.
Query whether the ability to claim valuation discounts will have been curtailed by then.
[v] The Don continued, “…but I thought that — that when it was your time — that — that you would be the one to hold the strings. Senator – Corleone. Governor – Corleone, or something…” A politician. I’ll leave it at that.
[vi] Nothing personal – just business.
[vii] Dixon v Comm’r, T.C. Memo 2019-79.
[viii] Employee leasing.
[ix] Presumably, Parents owned all of the issued and outstanding shares of stock.
[x] Ah, the trusting child.
[xi] Forms 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, and Forms 941, Employer’s Quarterly Federal Tax Return.
[xii] Form 4180. This form is prepared in order to assist the IRS is determining whether the individual interviewed may have been responsible for the collection and remittance of employment taxes.
[xiii] Letter 1153(DO)
[xiv] Form 2751.
[xv] Child later claimed not to have received notice of the certified mailing.
[xvi] Consistency is the mark of a champion, they say.
[xvii] So much for teaching your children well.
[xviii] Form 12153.
[xix] See IRC Sec. 6330(d)(1).
[xx] These include the employee’s share of (1) Social Security tax, see secs. 3101(a), 3102(a); (2) Medicare tax, see IRC Secs. 3101(b), 3102(a); and (3) Federal income tax, see IRC Secs. 3402(a)(1), 3403.
[xxi] IRC Sec. 7501(a).
[xxii] IRC Sec. 6672(a).
[xxiii] IRC Sec. 6671(b).
[xxiv] The term may be applied broadly.
The IRS collects the trust fund liability only once. Consequently, the IRS cross-references payments against the trust fund liability of the employer and payments against the TFRPs of responsible persons.
In addition, for circumstances in which there is more than one responsible person, a taxpayer who paid the TFRP may bring a separate suit against the other responsible person(s) claiming a right of contribution. Sec. 6672(d).
[xxv] IRC Sec. 6671(a).
[xxvi] More than $59.4 billion as of June 30, 2016. Query what the unreported amount is.
[xxvii] The breach of which would entitle the buyer to be indemnified by the seller for any resulting loss.
[xxviii] I wonder if this may be the same horse as the dead horse that one should stop beating. I did warn you about the flow of idioms today.
[xxix] See, e.g., IRC Sec. 2518, and N.Y. EPTL Sec. 2-1.11. In most cases, though, the right to disclaim is utilized as a tax planning tool.
[xxx] The god of death in Greek mythology, as distinguished from Hades, the god of the underworld and of the dead.
[xxxi] Which normally would be expected to remove not only the property from the donor’s estate, but also the post-gift appreciation in the value of the property and the income generated by the property.